function [Z,Zprob] = tauchenhussey(N,mu,rho,sigma,baseSigma)
% Function tauchenhussey
%
% Purpose:    Finds a Markov chain whose sample paths
%             approximate those of the AR(1) process
%                 z(t+1) = (1-rho)*mu + rho * z(t) + eps(t+1)
%             where eps are normal with stddev sigma
%
% Format:     {Z, Zprob} = TauchenHussey(N,mu,rho,sigma,m)
%
% Input:      N         scalar, number of nodes for Z
%             mu        scalar, unconditional mean of process
%             rho       scalar
%             sigma     scalar, std. dev. of epsilons
%             baseSigma scalar, std. dev. used to calculate Gaussian
%                       quadrature weights and nodes, i.e. to build the
%                       grid. I recommend that you use baseSigma = w*sigma +
%                       (1-w)*sigmaZ where sigmaZ = sigma/sqrt(1-rho^2),
%                       and w = 0.5 + rho/4. Tauchen & Hussey recommend
%                       baseSigma = sigma, and also mention baseSigma = sigmaZ.
%
% Output:     Z       N*1 vector, nodes for Z
%             Zprob   N*N matrix, transition probabilities
%
%     Martin Floden, Stockholm School of Economics
%     January 2007 (updated August 2007)
%
%     This procedure is an implementation of Tauchen and Hussey's
%     algorithm, Econometrica (1991, Vol. 59(2), pp. 371-396)

Z     = zeros(N,1);
Zprob = zeros(N,N);

[Z,w] = gaussnorm(N,mu,baseSigma^2);   % See note 1 below

%  [Z,w] = qnwnorm(N,mu,baseSigma^2);   % See note 1 below


for i = 1:N
    for j = 1:N
        EZprime    = (1-rho)*mu + rho*Z(i);
        Zprob(i,j) = w(j) * norm_pdf(Z(j),EZprime,sigma^2) / norm_pdf(Z(j),mu,baseSigma^2);
    end
end

for i = 1:N
    Zprob(i,:) = Zprob(i,:) / sum(Zprob(i,:),2);
end



function c = norm_pdf(x,mu,s2)
    c = 1/sqrt(2*pi*s2) * exp(-(x-mu)^2/2/s2);


function [x,w] = gaussnorm(n,mu,s2)
% Find Gaussian nodes and weights for the normal distribution
% n  = # nodes
% mu = mean
% s2 = variance

[x0,w0] = gausshermite(n);
x = x0*sqrt(2*s2) + mu;
w = w0 / sqrt(pi);


function [x,w] = gausshermite(n)
% Gauss Hermite nodes and weights following "Numerical Recipes for C"

MAXIT = 10;
EPS   = 3e-14;
PIM4  = 0.7511255444649425;

x = zeros(n,1);
w = zeros(n,1);

m = floor(n+1)/2;
for i=1:m
    if i == 1
        z = sqrt((2*n+1)-1.85575*(2*n+1)^(-0.16667));
    elseif i == 2
        z = z - 1.14*(n^0.426)/z;
    elseif i == 3
        z = 1.86*z - 0.86*x(1);
    elseif i == 4
        z = 1.91*z - 0.91*x(2);
    else
        z = 2*z - x(i-2);
    end
    
    for iter = 1:MAXIT
        p1 = PIM4;
        p2 = 0;
        for j=1:n
            p3 = p2;
            p2 = p1;
            p1 = z*sqrt(2/j)*p2 - sqrt((j-1)/j)*p3;
        end
        pp = sqrt(2*n)*p2;
        z1 = z;
        z = z1 - p1/pp;
        if abs(z-z1) <= EPS, break, end
    end
    if iter>MAXIT, error('too many iterations'), end
    x(i)     = z;
    x(n+1-i) = -z;
    w(i)     = 2/pp/pp;
    w(n+1-i) = w(i);
end
x(:) = x(end:-1:1);


% Note 1: If you have Miranda and Fackler's CompEcon toolbox you can use
% their qnwnorm function to obtain quadrature nodes and weights for the
% normal function: [Z,w] = qnwnorm(N,mu,baseSigma^2);
% Compecon is available at http://www4.ncsu.edu/~pfackler/compecon/
% Otherwise, use gaussnorm as here